Being a collection of thoughts, observations, comments, opinions and views on investing--especially for the long term.
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Sunday, February 04, 2007

Perseverance in Long-Run Investing (last of a five-part series)

Figure caption: Example of "beating the market." Sample portfolio with 10% CAGR over 6 years (2001-2006), versus S&P 500 with 1.2% CAGR over the same period. Sample portfolio goes from $100 at the beginning of 2001 to $177 at the end of 2006, versus $108 for S&P 500.

If you've been following along from the beginning of this series, you are now (at least hypothetically):

Today we'll put everything together and take a look at a few scenarios to see how long it will take to reach the $1 million goal I mentioned at the outset.

Wealth-Building Scenarios

How fast does your savings of $1,000 per month grow when diligently invested each and every month for the next 15 years? To run realistic scenarios, I assume that the "seed" amount you are able to save grows at a moderate inflation rate of 3% per year, meaning that this year you save 12 x $1,000 = $12,000; next year (in 2008) you save 3% more, or $12,360; the following year (in 2009) you save 3% more than that, or $12,730; and so on. As you save this money, you invest it primarily in equities (stocks and real estate) each year.

Although your return-on-investment (ROI) will vary from year to year, in accordance with the volatility of the market, for calculation purposes let's see where you will end up 15 years from now (in 2022) if you are able to achieve certain benchmark rates of return on your monthly savings (starting this year at $1,000 per month). Here's how the numbers look:

The graph and table below show the path your money follows as it grows over the 15-year investment period.

Certainly, if you are able to achieve a 20% ROI (which, by the way, would give you a stellar track record) in your investing, you will reach the zero-to-a-million-dollar goal by the end of 15 years. However, it is important to observe that you can also get to $1 million under the scenarios with a lower ROI (note: realistically speaking, these are the likely scenarios for most of us) by figuring out how to earn more from whatever work you do and (rather than spending your extra income) exercising the financial discipline to save and invest it. To reach $1 million in 15 years, here's what it takes:

a) At 5% ROI: Save and invest $3,000 per month;b) At 10% ROI: Save and invest $2,000 per month;c) At 20% ROI: Save and invest $1,000 per month.

Safety and Hope

For my own portfolio I like to have a blend of value and growth stocks. The value stocks are typically low P/E shares of well-established companies, conservatively run, generally large-cap, some of which pay dividends, and all of which have what I consider to be fairly predictable revenue, earnings and cash flow streams. The predictability of the underlying fundamentals gives me a sense of safety, i.e., assurance that the enterprise is almost "too big to fail" and will still be around in 10 years' time.

Examples of stocks in the value category are Citigroup (C, forward P/E of 11) and Berkshire Hathaway (BRKA or BRKB, forward P/E of 19), both of which I have held for over a decade. Another long-standing position is Equity Office Properties (EOP, forward P/FFO of 24), the REIT run by Sam Zell, which has become target of a private-equity bidding war between the Blackstone Group and another potential acquiror led by Vornado (VNO). (By the way, I also consider the house that I own and live in to be a value-oriented investment, since it is located in a fully built-out, stable neighborhood with decent long-term appreciation potential.)

Investing (and life) would be psychologically boring without the growth side, which complements the "safety" of the value side by introducing the more exciting element of "hope." The nature of growth stocks is higher P/Es, higher volatility, greater potential upside, typically no dividends, and younger underlying businesses with faster growth, often in the technology area.

An example of a growth stock in my portfolio is eBay (EBAY, forward P/E of 21), which I have held since shortly after its IPO in the late 1990s. I have also recently added Baidu (BIDU, forward P/E of 70), the Internet search leader in China, and Netease (NTES, forward P/E of 19), the leading Chinese gaming company with a horizontal portal, both of which I discussed in an earlier post covering Chinese Internet stocks.

In choosing your own portfolio, you will, of course, generally end up with a different selection of stocks (and ETFs, real estate and possibly mutual funds) than I have. However, regardless of the particular investments you select, I strongly recommend investing in a blend of value and growth, small cap and large cap, dividend-paying and not, domestic and foreign, tech and non-tech, young and old companies, etc. Once you seriously begin to run a "lumpy" portfolio with a few carefully selected stocks, you'll be surprised at how much diversification is actually possible with a very limited number (as few as 10 or so) positions in the mix.

Staying in the Game

Having come to this far in our discussion, you might be wondering if the investing methodology I am recommending really works. Will it enable you to accumulate wealth, achieve significant returns over the next 15 years, have a good chance of beating market benchmarks, and ultimately achieve your net worth goals?

First, in principle, I see no reason why the approach shouldn't deliver solid results, since the core assumptions behind the methodology are reasonable ones:

From a more practical perspective, I cannot offer conclusive, quantitative "proof" that the approach works, but I am willing to share my own experience to date. From 2001, when I began to manage my own money using the general "measured" approach outlined, I have kept track of my own performance. Somewhat to my own surprise (even though intellectually I am convinced that the approach "makes sense"), in each of the past six years I have managed to outperform the S&P 500, resulting in the sample portfolio return line displayed in the small figure at top of this article. Of course, as with any investing record, the future is what really counts and we will just have to wait and see if my outperformance continues in subsequent years.

A Monopoly board game analogy helps shed light on the nature of investment performance: Most people will agree that Monopoly is a game of both luck and skill--luck in rolling the dice and landing on the right properties at the right time (and skipping past other players' properties), and skill in trading properties with other players and deciding how rapidly to deploy your cash to build houses and hotels. After playing the game a handful of times with my own children and winning most of the time, I have begun to appreciate the role that skill plays at crucial junctures in the game. Sure, there is a great deal of luck involved but what I have noticed is that the eventual outcome of the game often hinges on particular decisions made by individual players, e.g., how much to pay for a property that's up for auction, or whether to prioritize obtaining all of the railroads for steady income or a complete color set of properties to begin building houses and hotels early in the game. In my opinion, the "investing game" that we all play in real life involves a luck-skill relationship much the same as in Monopoly--luck is important in short-term performance, but the many little skill-oriented decisions we make over the years soon enough add up to determine our long-run success as investors.

My closing advice: Save whatever you can and invest it, pursuing the measured approach I've outlined. In both up and down markets, stay in the game and be patient. Persevere through good and bad years and, with a little luck, you'll soon enough succeed in riding the market to the $1 million milepost and beyond.

Hi, In one of your earlier posts http://lloydsinvestment.blogspot.com/2006/03/taming-fat-tails-for-fatter-profits.html you calculate the historic PEG ratio. Could you help me out in doing the same? I checked yahoo and bigcharts but the most they do is p/e ratio. I will appreciate any help.

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This is a great blog post but I have an opposing view! Your closing advice is "save whatever you can and invest it". I say "BORROW whatever you can and invest it"! Don't use your own money. I don't mean be foolish, but borrow money with a home equity loan and invest so that the return surpasses the interest.

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